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What on Earth Happened to EEH?

From September 25 to November 4, the SPECTRUM Large Cap U.S. Sector ETN (EEH) gained a modest 10 percent. Hardly worth mentioning, really. Except that the 10 percent gain was anything but modest given what happened between those two dates. What happened to EEH between those dates was anything but modest, and it still seems to defy reason.

The Good Ole One-Month Seven-Bagger

From September 25 to October 21, EEH climbed 668 percent. No, that’s not a typo, it very nearly octupled in value in less than a month. And this massive spike was followed by an equally massive decline to follow, falling over 90 percent off its peak on October 21 in just two weeks. The phrase “volatility” suddenly seems inadequate to its purpose here. It’s a stock chart that resembles the Matterhorn. Heavily leveraged ETFs, micro-cap biotechs, no security sees a spike like this in a single month.

So what happened? How does this note take off like a rocket and then fall to earth just as fast? Long story short: no idea, whatsoever.

SPECTRUM Large Cap U.S. Sector Momentum Index

Unpacking this bizarre spike would appear to be relatively simple, but there’s several factors that help muddy the picture. For starters, when dealing with ETFs, movement’s pretty simple to explain. Most ETFs are tied to a specific index, and their movement is related to that index. And EEH is connected to the SPECTRUM Large Cap U.S. Sector Momentum Index. This is a weighted index based on the value of a notional portfolio consisting of the 10 sub-indices of S&P 500 that weights those sub-indices based on their performance, with heavier weight going to those sectors with better performance. So, essentially, if the health care sector is outperforming that market, this index weights it more heavily. And if energy is underperforming the S&P 500, it gets less weight.

So this means that there was an identical crazy spike for the SPECTRUM Large Cap U.S. Sector Momentum Index, right? No. Of course not. Literally everyone would have noticed if there was enough movement from S&P 500 companies to produce that kind of move. It would have been on the front page of every newspaper in the world, and joyous fund managers would be dancing in the streets into the wee hours of the morning.

ETNs vs. ETFs

So how does this happen? A part of the explanation comes from the difference between an exchange-traded fund (ETF) and an exchange-traded note (ETN). ETFs consist of equities assets of a composition that should guarantee that the fund’s value matches a particular indices. They don’t, really, do that perfectly, but it’s usually close enough. However, ETFs stay close to the value of their underlying reason because of the assets that back them. Any major gap between the fund and its underlying asset value would open up an opportunity for arbitrage and subsequently close that gap.

However, EEH is not an ETF. It’s an ETN. ETNs are an unsecured, unsubordinated debt security that pays returns based on the performance of a certain index. They are, in essence, a combination of a bond and an ETF. One purchases an ETN and, at the end of a predetermined time limit, you’re paid out based on the performance of the index minus any applicable fees. Unlike a bond, though, there are no coupon payments. Like bonds, one can trade them or hold them to maturity and collect the cash payment.

Trading Over Asset Value

One clear difference for an ETN is that it can trade at a different value than the underlying assets because it can’t be cashed in for the underlying assets. As such, the value of the ETN can open up a gap. For instance, the credit rating of the issuer can have a major effect on the value of an ETN, and a credit downgrade for the issuer might result in the note trading below the index value.

But this note didn’t trade below the index value. It traded above it. WAY above it. EEH is a pretty small note. It has assets of just $3.6 million, and its average volume is under 1,000 shares a day. However, at the peak of its October spike, the note was trading at a mind-boggling 645 percent its asset value.

How Does This Happen?

Which brings us to the primary question at hand: what the hell happened? A 650 percent spike in less than a month is insane. It’s even more insane when you consider the nature of the security being traded. Upon reaching maturity, you’ll be paid based on the index return regardless of what you paid for it.

So why would one pay more than seven times the note’s value? Did investors think the index would reach that performance before maturity? Probably not. It’s made up of American large-cap companies that simply don’t produce those sorts of returns. Did the issuing bank, Elements, a subsidiary of Merrill Lynch, which is a subsidiary of Bank of America (BAC) , promise that seven of these notes contained golden tickets that would allow holders to tour a magical chocolate factory? I mean, it’s a theory.

Momentum Trading on Momentum?

In the end, without a more plausible theory, one has to assume that this is just momentum investing run wild. This particular note traded on very low volume, so it’s not hard to see how large-volume buys could easily swing the note’s value. Any trader out there looking for ETNs trading above their asset value might have keyed on EEH and made big buys. And, of course, once it started to take off, who’s to say where it stops? If it keeps taking off at that rate, it’s clearly a buy, right?

Whether it was or not, the mindset could easily have led to a lot of traders looking for a quick dollar might have jumped on board. The more the note trades for, the more interest it gets from investment buyers, and before you know it we’re on the road to crazy town. And, as such, the 90 percent decline that followed the wild buying is the only predictable part of this story.

But the momentum investor explanation raises almost as many questions as it answers. Why THIS security? And why THIS much? One doesn’t have to look far to find a stock or security on the rise due to momentum buyers, but that still won’t find another example of a 650 percent gain in less than a month. So what was it about EEH that led to this sort of wild speculation?

“What happened was an extreme example of a market anamoly,” says Nicholas Bhandari, Quantitative Research Analyst with Equities.com. “You will occasionally see some premium above net asset value. But for it to rise above 640%? Shouldn’t ever happen. But what actually happened is a form of market piracy. I think people saw the initial spike and traders were attempting to profit off of it before the inevitable crash.”

“Extreme volatility can attract some very unscrupulous traders,” he concludes.

Efforts by Equities.com to contact Elements and BNP Paribas ($BNPQY), the bank that produces the SPECTRUM Index, failed to get a response, leaving this brief chapter of recent market history reading like an the first half of an episode of The Twilight Zone.

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